Tax Brackets Explained...

To save on taxes I believe you have to first understand how taxes work.

And understanding tax brackets and how they work is the starting point.

Additionally, understanding that tax brackets apply to the INCOME tax is key.

You see, there are many types of taxes. Property taxes, sales, tax, self employment tax… and the infamous INCOME TAX.

There are currently 7 income tax brackets or layers.

The tax brackets are:

10%

12%

22%

24%

32%

35%

37%

As you can see, there are some significant jumps in the brackets between certain levels.

These brackets are like layers of a cake in the sense that if you saw your income as a cake, each layer the government would want a slightly bigger percentage of that respective layer.

Key Terms

You may have heard terms such as Gross Income, Adjusted Gross Income, Standard Deduction, Itemized Deductions, and Taxable Income.

These are important terms to understand.

Gross Income is the sum of all income combined (Self Employed, Wages, Interest, Dividends, Partnership, Rental, etc.)

Adjusted Gross Income is the income after certain allowed deductions that are “above the line” deductions (retirement contributions, qualified expenses allowed for teachers, etc.)

Standard Deduction or Itemized Deductions are either the Standard Deduction allowed by the IRS for your filing status (Single, Head of Household, Married Filing Joint, or Married Filing Separately) or the combined Itemized Deductions that are allowed (things such as qualified charitable donations, mortgaged interest deductions, property taxes and state income taxes, etc.)

For the Standard vs Itemized deductions you take the larger of the two options to reduce your income.

Taxable Income is the final amount of income that the government wants to take a bite out of after all of these adjustments and deductions.

Whew… ok… that was a lot.

But it’s important to understand these basic things to be able to build a foundation on which to build tax savings!

At this point, we arrive at that cake that the government has their eyes on like a small child in a bakery shop!

They have an insatiable sweet tooth.

And the more of the cake there is to eat, the more their sweet tooth screams “let me at it!”

If you’ve heard the term “progressive tax system” what that means is that the tax progressively gets higher as your income increases. In short, each layer of income they take more of of that layer.

It’s progressive in the sense that the system applies a heavier burden on those who make more and less on those who make more.

Let’s say that you’re making around $70,000 a year.

That would put you squarely in the 22% tax bracket.

But that’s not a total 22% of the $70,000.

A flat 22% of $70,000 would be $15,200.

But that’s not actually how our tax system works.

The first layer of that tasty income cake is in the 10% “bracket”, the second layer is in the 12% “bracket” and the last layer of the cake jumps into the 22% “bracket”.

And at each “bracket” the government wants to take a percentage of that layer.

Here is an example,

$70,000 - $12,950 (Standard deduction) = 57,050

57,050 (Taxable income)

Layer at 10% bracket = 10% x $9,950 (the 2022 layer that is taxed at the 10% rate)

Layer at 12% bracket = 12% x $30,575 (the 2022 layer that is taxed at the 12% rate)

Layer at 22% bracket = 22% x $16,525 (the 2022 layer that is taxed at the 22% rate)

Those percentages added up are:

$995 + $3,669 + $3,635.5 = roughly $8,300 in taxes that you owe.

As you can see in this example, your taxable income is taxed at every single bracket until it reaches its final bracket at 22%.

But because you are paying taxes progressively and not a single 22% flat tax, that means you’re paying less than 22% in taxes…

In this example above, you’re paying around 11.9% in taxes, which equals about $8,300 that you owe the IRS.

This is what is known as your total EFFECTIVE rate.

Why does this matter?

I believe that when you begin to understand just how big of a bite the government takes out of your cake it helps to frame the importance of all of the things that make up tax savings strategies!

What we’ve covered here only covers the Federal income tax. If your State and City have their own respective income taxes and brackets that only compounds the problem of the “tax bite.”

Understanding the impact of the brackets helps you understand how much more valuable that tax credit that you are missing or those deductions that you didn’t take the time to track.

I love Simon Sinek and his “Start With Why” book. Understanding the “Why” of tax savings in this sense helps drive lasting change.

You see, the government has a system to take our money! Fight back with a system to save money and STOP wasting money on taxes!